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Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and are
expressed as a comparison of the currencies of two countries. The following are
some of the principal determinants of the exchange rate between two countries.
Note that these factors are in no particular order; like many aspects of economics,
the relative importance of these factors is subject to much debate.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies.
During the last half of the 20th century, the countries with low inflation included
Japan, Germany and Switzerland, while the U.S. and Canada achieved low
inflation only later. Those countries with higher inflation typically
see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency values.
Higher interest rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve
to drive the currency down. The opposite relationship exists for decreasing interest
rates - that is, lower interest rates tend to decrease exchange rates.

3. Current-Account Deficits

The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest and
dividends. A deficit in the current account shows the country is spending more on
foreign trade than it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. In other words, the country requires more foreign currency
than it receives through sales of exports, and it supplies more of its own currency
than foreigners demand for its products. The excess demand for foreign currency
lowers the country's exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to generate sales for
domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign
investors. The reason? A large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real dollars in the
future.

In the worst case scenario, a government may print money to pay part of a large
debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of
securities for sale to foreigners, thereby lowering their prices. Finally, a large debt
may prove worrisome to foreigners if they believe the country risks defaulting on
its obligations. Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the country's debt rating
(as determined by Moody's or Standard & Poor's, for example) is a crucial
determinant of its exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports
rises by a greater rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides
increased demand for the country's currency (and an increase in the currency's
value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to have
more political and economic risk. Political turmoil, for example, can cause a loss
of confidence in a currency and a movement of capital to the currencies of more
stable countries.

Determination of exchange rates using supply and demand diagram

In this example, a rise in demand for Pound Sterling has led to an increase in the value of the £ to
$ – from £1 = $1.50 to £1 = $1.70

Note:

 Appreciation = increase in value of exchange rate


 Depreciation / devaluation = decrease in value of exchange rate.

Factors that influence exchange rates

1. Inflation
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more
competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also
foreign goods will be less competitive and so UK citizens will buy less imports.

 Therefore countries with lower inflation rates tend to see an appreciation in the value of their
currency. For example, the long term appreciation in the German D-Mark in post-war period was
related to the relatively lower inflation rate.

2. Interest rates

If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in
the UK. You will get a better rate of return from saving in UK banks, Therefore demand for
Sterling will rise. This is known as “hot money flows” and is an important short run factor in
determining the value of a currency.

 Higher interest rates cause an appreciation.


 Cutting interest rates tends to cause a depreciation

3. Speculation

If speculators believe the sterling will rise in the future, they will demand more now to be able to
make a profit. This increase in demand will cause the value to rise. Therefore movements in the
exchange rate do not always reflect economic fundamentals, but are often driven by the
sentiments of the financial markets. For example, if markets see news which makes an interest
rate increase more likely, the value of the pound will probably rise in anticipation.
The fall in the value of the Pound post-Brexit was partly related to the concerns that UK would
no longer attract as many capital flows outside the Single Currency.

4. Change in competitiveness

If British goods become more attractive and competitive this will also cause the value of the
exchange rate to rise. For example, if the UK has long-term improvements in labour market
relations and higher productivity, good will become more internationally competitive and in
long-run cause an appreciation in the Pound. This is a similar factor to low inflation.

5. Relative strength of other currencies

In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were
worried about all the other major economies – US and EU. Therefore, despite low interest rates
and low growth in Japan, the Yen kept appreciating. In the mid 1980s, the Pound fell to a low
against the Dollar – this was mostly due to strength of Dollar, caused by rising interest rates in
the US.

6. Balance of payments
A deficit on the current account means that the value of imports (of goods and services) is
greater than the value of exports. If this is financed by a surplus on the financial / capital account
then this is OK. But a country who struggles to attract enough capital inflows to finance a current
account deficit, will see a depreciation in the currency. (For example current account deficit in
US of 7% of GDP was one reason for depreciation of dollar in 2006-07). In the above diagram,
the UK current account deficit reached 7% of GDP at the end of 2015, contributing to the decline
in the value of the Pound.

7. Government debt

Under some circumstances, the value of government debt can influence the exchange rate. If
markets fear a government may default on its debt, then investors will sell their bonds causing a
fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a rapid
fall in the value of the Icelandic currency.

For example, if markets feared the US would default on its debt, foreign investors would sell
their holdings of US bonds. This would cause a fall in the value of the dollar. See: US dollar and
debt

8. Government intervention
Some governments attempt to influence the value of their currency. For example, China has
sought to keep its currency undervalued to make Chinese exports more competitive. They can do
this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

 see also: Chinese Currency | Swiss Franc pegged against Euro

9. Economic growth / recession

A recession may cause a depreciation in the exchange rate because during a recession interest
rates usually fall. However, there is no hard and fast rule. It depends on several factors.

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